Economic Equity vs. Control Equity

One of the most common mistakes in equity-for-services deals is conflating ownership with control. These are separate rights that can and should be structured independently.

Economic Rights

  • Right to receive dividends/distributions
  • Share of proceeds on sale or liquidation
  • Profit interest in ongoing operations
  • Anti-dilution protections
  • Tag-along rights on sale
  • Participation in future rounds

Control Rights

  • Voting rights on company matters
  • Board seat appointments
  • Veto power over major decisions
  • Information and inspection rights
  • Approval of key transactions
  • Ability to remove officers

Why Separation Matters

A service provider can receive meaningful economic upside without having the ability to block business decisions or force stalemates. This protects both parties:

  • For founders: Retain operational control while compensating key contributors fairly
  • For service providers: Receive clear economic stake without governance responsibilities
  • For investors: Know that key decisions require consent of appropriate parties

Common Structures

  • Non-voting equity: Full economic participation, no voting rights
  • Profits interest: Share of future profits only, typically no voting
  • Phantom equity: Cash payments tied to equity value, no actual ownership
  • Restricted stock: Full equity with vesting, voting rights may be restricted until vested

Voting Rights: Common vs. Preferred

In corporations, different classes of stock have different voting rights. Understanding this structure is essential when negotiating equity compensation.

Common Stock

Common stock is the basic equity ownership unit. Typical features include:

  • One vote per share on stockholder matters
  • Elects board of directors (usually)
  • Last in line for liquidation proceeds (after debt and preferred)
  • Participates in dividends if declared
  • Often divided into classes (A, B, etc.) with different voting power

Preferred Stock

Preferred stock typically held by investors has special rights:

  • Liquidation preference (get money back first)
  • Protective provisions (veto rights over key decisions)
  • May or may not have voting rights on general matters
  • Often converts to common stock on IPO or sale
  • Anti-dilution protection

Dual-Class Stock Structures

Many startups issue founder stock with super-voting rights (e.g., 10 votes per share vs. 1 vote for other common stock). This allows founders to raise capital without losing control. If you receive common stock, understand whether it has the same voting power as founder shares.

LLC Voting Rights

LLCs have more flexibility than corporations. Voting can be structured:

  • Per capita: One vote per member regardless of ownership percentage
  • Pro rata: Voting power proportional to ownership percentage
  • By class: Different classes with different voting rights
  • Manager-managed: Members have limited voting; managers make most decisions

Board Seats and Observer Rights

Board representation gives direct input into company governance. However, board seats come with fiduciary duties and potential liability.

Board Seat Rights

A board seat provides:

  • Direct vote on board-level decisions
  • Fiduciary duty to all shareholders (not just your class)
  • Access to detailed financial and operational information
  • Ability to hire/fire officers
  • Approval of major contracts and transactions
  • Oversight of company strategy and budget

Board Member Liability

Board members have fiduciary duties of care and loyalty. They can be personally liable for:

  • Breach of fiduciary duty
  • Approving fraudulent transactions
  • Failure to exercise proper oversight
  • Self-dealing or conflicts of interest

Ensure the company has D&O insurance and appropriate indemnification provisions before accepting a board seat.

Observer Rights

An alternative to a board seat is observer rights. Observers can:

  • Attend board meetings (usually without vote)
  • Receive board materials and financial reports
  • Participate in discussions
  • Provide input and ask questions

Observers typically do NOT have:

  • Voting rights on board matters
  • Fiduciary duties (in most cases)
  • Right to attend executive sessions
  • Access to attorney-client privileged communications

When to Choose Observer Rights

Observer rights may be preferable if you want information access without governance responsibility, especially if:

  • You are a service provider, not an investor
  • You have a minority economic stake
  • You want to avoid fiduciary duty complications
  • The company has existing investors with board control

Protective Provisions (Veto Rights)

Protective provisions give certain stockholders the right to block specific corporate actions, regardless of their voting power on general matters. These are critical for minority protection.

Governance Rights Matrix

Right Majority Common Minority Holder Board Approval
Elect Directors Yes If granted N/A
Approve Merger/Sale Yes If protective provision Yes
Amend Charter Yes If affects class rights Yes
Issue New Equity Usually no If protective provision Yes
Take on Debt Usually no If protective provision Yes
Hire/Fire CEO No No Yes
Approve Budget No No Yes
Access Information Statutory rights Statutory rights Yes

Common Protective Provisions

Actions Requiring Special Consent

1
Sale or Merger

Any sale, merger, or change of control transaction requires consent of holders of [X]% of the shares.

2
Issuance of New Equity

Issuing new shares or equity interests that dilute existing holders requires consent.

3
Incurring Significant Debt

Taking on debt above a threshold amount requires holder consent.

4
Related Party Transactions

Any transaction with directors, officers, or major stockholders requires disinterested approval.

5
Changing Charter/Bylaws

Amendments that affect the rights of a class require consent of that class.

6
Dividend Declarations

Declaring dividends or distributions may require approval if they affect liquidity.

7
Changing Board Size

Increasing or decreasing the number of directors requires consent to prevent dilution of board influence.

8
Material Contracts

Entering into contracts above a threshold value or outside ordinary course requires approval.

Information Rights

As an equity holder, you need information to understand the value of your stake and verify that the company is being managed properly.

Standard Information Rights

  • Annual financial statements: Balance sheet, income statement, cash flow statement
  • Quarterly updates: Unaudited financial summaries and operational metrics
  • Cap table: Current ownership structure and outstanding securities
  • Board materials: Meeting minutes and resolutions (if observer rights)
  • Tax documents: K-1s for LLCs, any required tax reporting

Enhanced Information Rights

Major investors often negotiate additional rights:

  • Audited financials: Especially for larger investments
  • Monthly reporting: Financial and operational metrics
  • Annual budget: Review of planned spending and projections
  • Inspection rights: Ability to examine books and records
  • Management presentations: Regular updates from leadership

Confidentiality Obligations

Information rights typically come with confidentiality obligations. You cannot share company financials or strategic information with competitors, the press, or other parties. Violating confidentiality can result in losing your information rights or legal liability.

Deadlock Prevention: Avoiding 50/50 Disasters

Equal splits of voting power create the risk of deadlock, where neither party can make decisions without the other's consent. This can paralyze a company.

The 50/50 Trap

When two founders or parties each own 50% of voting power:

  • Every decision requires unanimous consent
  • Disagreements cannot be resolved by voting
  • One party can block any action indefinitely
  • Personal relationships become the only dispute mechanism
  • Investors often refuse to invest in 50/50 companies

Deadlock Prevention Mechanisms

1. Unequal Voting Splits

The simplest solution is to avoid 50/50 in the first place. Even a 51/49 split provides a tiebreaker. Consider:

  • One person has final decision authority on day-to-day matters
  • Different decision domains for different founders
  • Casting vote for one party on board deadlocks

2. Independent Tiebreaker

Add a third party to break ties:

  • Independent board member with tiebreaking vote
  • Advisory board that can mediate disputes
  • Designated third party for specific decisions

3. Mandatory Mediation/Arbitration

Require dispute resolution before deadlock becomes permanent:

  • Escalation to mediation after defined period
  • Binding arbitration for unresolved disputes
  • Designated decision-maker for specific categories

4. Shotgun/Texas Shootout Clauses

Buy-sell mechanisms that force resolution:

  • Shotgun clause: One party offers to buy the other out at a price; the other party must either sell at that price or buy the first party out at the same price
  • Texas shootout: Both parties submit sealed bids; highest bidder buys out the other
  • Right of first refusal: If one party wants out, the other gets first chance to buy

Example: Shotgun Clause in Action

Founder A and Founder B are deadlocked on company direction. Founder A invokes the shotgun clause and offers to buy Founder B's 50% for $500,000.

Founder B must now either: (1) sell their 50% to Founder A for $500,000, or (2) buy Founder A's 50% for $500,000.

This forces fair pricing because the offering party could end up on either side of the transaction.

5. Vesting with Acceleration

For service providers, build in mechanisms that resolve disputes over time:

  • Single-trigger acceleration on termination without cause
  • Buyback rights at fair market value
  • Put/call options after defined periods

How to Structure Deals That Avoid Founder Disputes

The best time to prevent disputes is before they happen, when everyone is still excited about working together. Structure your deal to anticipate problems.

Key Structural Elements

  1. Clear decision authority: Define who has final say on what categories of decisions
  2. Written operating agreement: Document all governance terms, do not rely on verbal understandings
  3. Vesting for everyone: No one should get unvested equity, including founders
  4. Defined exit scenarios: What happens if someone wants out, dies, or becomes disabled?
  5. Dispute resolution process: Mediation, arbitration, or other mechanism before litigation
  6. Regular valuation: Agree on how to value the company for buyouts
  7. Role definitions: Who is responsible for what, and how are changes made?

Best Practices for Service Provider Equity

  • Receive economic rights proportionate to your contribution
  • Accept limited control rights unless you are a true co-founder
  • Negotiate information rights to monitor your investment
  • Ensure vesting protects you from arbitrary termination
  • Get protective provisions for major decisions that affect your stake
  • Document everything in writing before starting work

Questions to Answer Before Accepting Equity

  1. What percentage of the company am I receiving (fully diluted)?
  2. What voting rights come with my equity, if any?
  3. Who controls the board, and will that change?
  4. What decisions require my consent?
  5. What information will I receive and how often?
  6. What happens to my equity if I leave or am terminated?
  7. How are disputes between equity holders resolved?
  8. What happens if the company is sold or raises more money?
  9. Do I have any transfer restrictions or rights of first refusal?
  10. What are my obligations as an equity holder?